The bond (especially MBS/ABS) market thinks the world is about to end. From the MBS/ABS markets via SIVs into money market funds, thence into auction-securities, and the adjustable-rate muni markets via the highly likely bankrupt bond insurers, this contagion has spread. On the other hand, the equity markets largely ignored these developments until last October.
Since then, they have dropped 10-20% depending on the specific index you look at.
Meanwhile, commodities have only strengthened within that period, and equities that apparently benefit from higher commodity prices have remained strong relative to the equity indices as well. This disconnect between bonds, equities and commodities needs explaining.
After all, they are all part of the same economy. Commodity demand comes not just from overseas countries (though much of the growth in commodity demand may have come from emerging markets, if you look at the absolute level, the US, Europe and Japan still account for the majority of THE LEVEL of commodities consumed). Assume we are about to hit a recession which could be quite severe and long-lasting in the U.S. (to take the savings rate from 0% to 5% requires about a 4% reduction in GDP in 1 year, or, alternatively, a 2% drop combined with 2% contribution from inflation, along with no drop in corporate consumption/household income). Also suppose that Japan does too with a short lag, and that Europe barely avoids one, growing at about 0.5% (ie Spain, UK drop, others grow). This implies a drop in commodities demand from the largest 3 blocks; even assuming that there is no drop in the growth rate in demand from emerging markets (which is quite unlikely since their biggest importers are: EU, US, Japan!), this requires a significant net drop in demand for most commodities.
Now the supply side - only oil and copper are in the realm of true shortages of production relative to demand. The rest are close, barring stories of wheat fungus spreading.
Nevertheless, futures both near month and out month have marched relentlessly higher until relatively late in March.
Are the bond market and the NASDAQ wrong, or is it merely that the commodities space is the last refuge of the momentum players pumping yet another micro-market up using the trumpets playing once again the siren-song of decoupling?
We subscribe to the latter view. We do not advocate building too rapidly an anti-commodity position or one that requires an abrupt fall immediately. Bubbles such as this have always tended to take just a little longer to peak, and certainly to fall. So selling calls into this, especially repeated selling of short-dated (e.g. near month) calls after temporary spikes, letting the time value eat away (esp given the high level of vol), right now seems more prudent than outright shorts, or, heaven forbid, the purchase of puts and via it the high time premiums therein embedded.
Patience, gentle grasshopper.
Friday, March 28, 2008
Thursday, March 27, 2008
Role of Macro Trends to Investing and Current Biggies
In the last post we mentioned that we are not 'macro' fund managers, but that we do not believe in simply 'bottom-up' either. Here is how it works: we think macro-trends helps you find or avoid. For example, knowing and understanding the housing bubble and its link to the debt bubble, to the trade deficit/capital account, and to the level of leverage that different types of entities were using (relative especially to levels that history has shown to be prudent) was essential if you were to avoid losing money in the last year.
On the other hand, bottom-up analysis is also important. It is what helped us differentiate Lehman Brothers and Goldman Sachs from Bear Stearns on the day that Bear collapsed, and the other broker-dealers fell in sympathy. If you had sold near-month just out of the money puts struck at $25 (why selling puts was the best strategy is for another post) on lehman when it fell in sympathy, for a few more days of risk, you could have earned about 2900 dollars for each 10,000 risked. That is right, that day (March 17th) we saw an opportunity to make 29% between March 17th and the day March options expired (March 22nd) WITH NO CASH OUTLAY but requiring sufficient capital to back up the puts. The only way we would have lost money was if Lehman was indeed going to go the way of Bear. We were pretty sure this was not going to happen because (1)the Fed had just opened the discount window to all broker dealers and (2)Lehman had the best liquidity ratio of the lot.
What, precisely, are our big macro views?
1. The hibernation of the US Consumer for the next 2 years or so with slow revival thereafter (so don't rely on the next 3-4 yrs of cash flows if your company only sells to US individual consumers).
2. Temporary slow down globally, with outright recession probable in Japan, somewhat probable in the EU area, and a virtual certainty in the US. This should make emerging markets slow a lot, but different countries will have vastly different experiences depending on their exposure to exports vs domestic demand resilience.
3. Recovery will begin first (and potentially even a slow-down may be avoided) by companies who sell primarily into emerging markets, to governments or to other companies that are positioned to make large capital outlays. Companies that rely on the US consumer should be avoided unless (a)the valuation is extremely compelling (b)their plans include international growth and (c)their moat is pretty damn wide.
This view has led us to short financials and housing while being long cash, only certain segments of health care and a certain very large and well-managed diversified insurance/ manufacturing/ energy conglomerate based out of Omaha, Nebraska. We have largely held these views and positions since the middle of 2006, with some rebalancing mostly on the shorts as some of our best-chosen shorts went bankrupt or the stock fell so much that it was just as good to get out before bankrupcy (ie New Century, which actually did go bankrupt, vs CFC/MBI/ABK which eventually got into low single-digits from mid double digits) to re-use that capital on shorts with a better risk-return profile.
On the other hand, bottom-up analysis is also important. It is what helped us differentiate Lehman Brothers and Goldman Sachs from Bear Stearns on the day that Bear collapsed, and the other broker-dealers fell in sympathy. If you had sold near-month just out of the money puts struck at $25 (why selling puts was the best strategy is for another post) on lehman when it fell in sympathy, for a few more days of risk, you could have earned about 2900 dollars for each 10,000 risked. That is right, that day (March 17th) we saw an opportunity to make 29% between March 17th and the day March options expired (March 22nd) WITH NO CASH OUTLAY but requiring sufficient capital to back up the puts. The only way we would have lost money was if Lehman was indeed going to go the way of Bear. We were pretty sure this was not going to happen because (1)the Fed had just opened the discount window to all broker dealers and (2)Lehman had the best liquidity ratio of the lot.
What, precisely, are our big macro views?
1. The hibernation of the US Consumer for the next 2 years or so with slow revival thereafter (so don't rely on the next 3-4 yrs of cash flows if your company only sells to US individual consumers).
2. Temporary slow down globally, with outright recession probable in Japan, somewhat probable in the EU area, and a virtual certainty in the US. This should make emerging markets slow a lot, but different countries will have vastly different experiences depending on their exposure to exports vs domestic demand resilience.
3. Recovery will begin first (and potentially even a slow-down may be avoided) by companies who sell primarily into emerging markets, to governments or to other companies that are positioned to make large capital outlays. Companies that rely on the US consumer should be avoided unless (a)the valuation is extremely compelling (b)their plans include international growth and (c)their moat is pretty damn wide.
This view has led us to short financials and housing while being long cash, only certain segments of health care and a certain very large and well-managed diversified insurance/ manufacturing/ energy conglomerate based out of Omaha, Nebraska. We have largely held these views and positions since the middle of 2006, with some rebalancing mostly on the shorts as some of our best-chosen shorts went bankrupt or the stock fell so much that it was just as good to get out before bankrupcy (ie New Century, which actually did go bankrupt, vs CFC/MBI/ABK which eventually got into low single-digits from mid double digits) to re-use that capital on shorts with a better risk-return profile.
Introduction
I would like to elaborate on the blog description for the first post. Most commentators on the web focus on a narrow area (equities, or currency, or commodities) and ignore the most important of the three components of what constitutes a good trade idea - that it isn't already shared widely and hence priced into a security. It is relatively more easy to have ideas that are true (say 60-70% of the time) and affect the value of some security. What is hard is finding the ideas that a gazillion other people haven't thought of, and figuring out if a particular view has already been factored into a price already/is consistent with the price.
Our strategy for finding these good trade ideas is to focus on what is obviously missing in most published analysis (whether it be from Dealer Research or the popular press): an appreciation of (a)long time horizons (b)the big picture and common sense (c)a basic understanding of how to value cash flows on a discounted basis. Let me address each of these in turn with examples:
(a)time horizons: right now, when it comes to the US economy and equity markets, everyone seems to be focused on the Fed, liquidity, and the credit crunch. While these are important in the short-run, especially if you are looking at fairly leveraged companies close to having to roll their debt over, in selecting your long-term longs you should only use liquidity as a constraint (ie avoid those that could go under). But always the first thing you should be looking for is a good/growing moat at a reasonable value. This is also related to
(b)the big picture and common sense: the problems did not begin and do not end with the Fed. The problem is the combination of overindebtedness, low savings rate, recent drop in risk-premiums and the sudden return of common sense (at least to the bond markets if not quite the equity or commodity markets yet). As the housing bubble grew, more and more exotic types of mortgages were created which pumped house prices up further, and these were made to increasingly bad borrowers at increasingly low risk-premiums!! Meanwhile, as everyone felt richer because their house price was going up, they felt less need to save. In addition, a lot of the people who bought in 2004-2007 bought such overpriced places relative to their income that they simply had no cash flow TO SAVE after paying taxes and basic costs of living. So let's focus on that rather than the Fed when we consider the long time horizon trades (which to me means five or more years).
(c)How to value cash flows for a company/stock: pick a starting earnings level of 1.00. Project a growth rate out year by year in Excel for the first 5-10 years, then have it revert to the long-term nominal rate of GDP (call this 7% for now). Use a rate with which to discount (e.g. 10%).
Make sure the long-term rate growth reverts to and the discount rate are cells you can change (ie use links and formulas). Starting with each future year grow a column of earnings by your projected growth rates. Discount each of these in a subsequent column by your chosen discount rate. Finally sum up this discounted cash flow column out to 40 years. Also, sum up the first 5 years, the first 10 years, and the second 10 years separately. These will be useful for sensitivity analysis. The sum represents the multiple of current earnings you should be willing to pay for that company/stock if your subjective hurdle rate is the discount rate you have chosen.
Most people who write about equities ignore this basic analysis. The point is not that anyone can forecast those growth rates precisely and "get it right" - no one can do that, not even Mr. Buffett himself. The point is that without doing this, or something similar in a simpler and more heuristic way (with experience one can do this analysis mentally), you have no idea what the right PE should be. People come up with dumb rules, like "any P/E under 14 is cheap" or even worse start using things like the PEG ratio.
In addition to this basic strategy (the quantitative part ends with (c) above, we need to learn how to (a)read balance sheets and income statements (b)become poets, philosophers and historians at heart. I mention these 3 because these are discliplines which really teach you about hidden connections, non-linear thinking, being sceptical of everything you hear, and having the big and long-term picture. After you have understood balance sheets, income statements and valuation, the most important thing to do is to read a little about a lot, a modest amount about a modest number of things, and enough to become an expert on a small set of things that matter a lot at that historical moment.
Our approach is neither 'macro investing' (ie bet on housing collapse via ABX index, or collapse of US dollar via futures against Chinese currency) nor ignoring all the macro stuff like so many mutual funds promise to do while they focus on "bottom-up stock selection". The first to us seems to often be too broad (relying on understanding and forecasting rather complex systems quite well), and the second to be too much like trying to find the strongest house in LA
before the biggest earthquake of the century when you could simply buy a ticket to NY.
The next post will focus on where we feel 'the right' balance between the micro and the macro focus is and will begin with our current macro view.
Our strategy for finding these good trade ideas is to focus on what is obviously missing in most published analysis (whether it be from Dealer Research or the popular press): an appreciation of (a)long time horizons (b)the big picture and common sense (c)a basic understanding of how to value cash flows on a discounted basis. Let me address each of these in turn with examples:
(a)time horizons: right now, when it comes to the US economy and equity markets, everyone seems to be focused on the Fed, liquidity, and the credit crunch. While these are important in the short-run, especially if you are looking at fairly leveraged companies close to having to roll their debt over, in selecting your long-term longs you should only use liquidity as a constraint (ie avoid those that could go under). But always the first thing you should be looking for is a good/growing moat at a reasonable value. This is also related to
(b)the big picture and common sense: the problems did not begin and do not end with the Fed. The problem is the combination of overindebtedness, low savings rate, recent drop in risk-premiums and the sudden return of common sense (at least to the bond markets if not quite the equity or commodity markets yet). As the housing bubble grew, more and more exotic types of mortgages were created which pumped house prices up further, and these were made to increasingly bad borrowers at increasingly low risk-premiums!! Meanwhile, as everyone felt richer because their house price was going up, they felt less need to save. In addition, a lot of the people who bought in 2004-2007 bought such overpriced places relative to their income that they simply had no cash flow TO SAVE after paying taxes and basic costs of living. So let's focus on that rather than the Fed when we consider the long time horizon trades (which to me means five or more years).
(c)How to value cash flows for a company/stock: pick a starting earnings level of 1.00. Project a growth rate out year by year in Excel for the first 5-10 years, then have it revert to the long-term nominal rate of GDP (call this 7% for now). Use a rate with which to discount (e.g. 10%).
Make sure the long-term rate growth reverts to and the discount rate are cells you can change (ie use links and formulas). Starting with each future year grow a column of earnings by your projected growth rates. Discount each of these in a subsequent column by your chosen discount rate. Finally sum up this discounted cash flow column out to 40 years. Also, sum up the first 5 years, the first 10 years, and the second 10 years separately. These will be useful for sensitivity analysis. The sum represents the multiple of current earnings you should be willing to pay for that company/stock if your subjective hurdle rate is the discount rate you have chosen.
Most people who write about equities ignore this basic analysis. The point is not that anyone can forecast those growth rates precisely and "get it right" - no one can do that, not even Mr. Buffett himself. The point is that without doing this, or something similar in a simpler and more heuristic way (with experience one can do this analysis mentally), you have no idea what the right PE should be. People come up with dumb rules, like "any P/E under 14 is cheap" or even worse start using things like the PEG ratio.
In addition to this basic strategy (the quantitative part ends with (c) above, we need to learn how to (a)read balance sheets and income statements (b)become poets, philosophers and historians at heart. I mention these 3 because these are discliplines which really teach you about hidden connections, non-linear thinking, being sceptical of everything you hear, and having the big and long-term picture. After you have understood balance sheets, income statements and valuation, the most important thing to do is to read a little about a lot, a modest amount about a modest number of things, and enough to become an expert on a small set of things that matter a lot at that historical moment.
Our approach is neither 'macro investing' (ie bet on housing collapse via ABX index, or collapse of US dollar via futures against Chinese currency) nor ignoring all the macro stuff like so many mutual funds promise to do while they focus on "bottom-up stock selection". The first to us seems to often be too broad (relying on understanding and forecasting rather complex systems quite well), and the second to be too much like trying to find the strongest house in LA
before the biggest earthquake of the century when you could simply buy a ticket to NY.
The next post will focus on where we feel 'the right' balance between the micro and the macro focus is and will begin with our current macro view.
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